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The Nifty has crossed 5500 and the Sensex is at 18300. There may be no core fundamentals backing a rally of this magnitude but that does not matter. As I wrote in my previous article, we are in a purely liquidity driven rally.

However, this rally has also taught me a lot in addition. First of all, rallies are powerful only when driven by liquidity, not fundamentals. Fundamentals play only a supporting role. The Fed’s unleashing of liquidity in 2009 kickstarted the recovery from the lows. The ECB’s unleashing has done it now.

It doesn’t really matter if there are no fundamentals because when money is cheap, risky assets like stocks will move up. It is also true that the markets will fall but that will happen not because of waning fundamentals but waning liquidity. Go back to 2008 and you will see that decreasing liquidity preceded the fall and the bottom was reached at the time of the worst liquidity crunch in a long, long time.

When there is a clear trend in stock markets, fantastic money is made in a very short time frame. However, then the fall, consolidation etc. comes which tempers the long term returns significantly. Thus as the time in the markets increases, the returns become far less impressive. We have witnessed a 20%+ rise in the benchmark indices and more in the midcap indices. People have made more much money in this time frame than investors have made in four years(even not adjusting for inflation.

The very long term is supposed to belong to fundamentals but that is entirely a function of the point at which the investor is evaluating his investment. Companies with great fundamentals languish at lows because there is no buying interest (no liquidity) while bogus companies run up like crazy.

The fundamentals basically are needed to sustain a stock at higher levels otherwise it falls when liquidity dries up. However, when liquidity for the entire market dries up, even strong stocks fall rapidly and so one can avoid losses only if one has entered at lower levels.

In toto, better to play liquidity for market trends than fundamentals. As long as liquidity continues to flow in the financial system, there will be no correction in the Indian bourses.

The month of January 2012 seems to have descended straight out of the good old days of 2003-2007. With the Sensex trading at around 17500 and the Nifty near 5300, nobody is remembering the bearish days of December. There has been more than 12% gains in the benchmark indices and much more than that in individual stocks. Even midcaps have rallied. So is this really one of the sunshine months of those wonderful years?

Like the mid 2000s?

Only partly. The part which does agree with that period is liquidity. In those years, the markets were awash with funds, funds which were responsible for the stock market and commodity market bubbles worldwide. We saw how liquidity changed sentiment when Bernanke released QE1 into the markets in 2009 leading to one of the fastest pullbacks ever in equity markets. This flood of liquidity is back and is showing no signs of ebbing. FIIs put over 10000 crores in Indian markets in the last one month and are putting in more each day.
Another common thing is that people have been wringing hands as they have been unable to get in. There is money on the sidelines that is jittery and likely being deployed at ever higher levels.
However, apart from that, there is little in common with mid 2000s. The market fundamentals are very weak and the markets are looking quite expensive. There has hardly been any significant positive news to justify the price increases. Europe, US, China and India: all four have growth problems in descending order of magnitude. The actions in the US and Europe have been to brush the problems under the carpet and in fact there has been no effort to really solve the intrinsic problems of the economies. The mid 2000s were based on real earnings increases which were sustainable in the long run (the absolute earnings being sustainable, not the increases).

Another big difference has been in volumes. Cash market delivery volumes are nowhere near levels which were common in those years. Retail investors continue to stay away from the markets. A bull market rally rarely runs on small volumes. That is more the characteristic of a bear market rally.

Liquidity: the ultimate steroid

The markets are on steroids and steroids as any doctor will tell you are very effective and powerful. Forget fundamentals, the Sensex could even take out another 1000 points on this rally. There is after all, no resistance on the upside as people are too scared to short. You see, the absolute absence of fundamentals in this rally gives it the feel of a pure momentum play and it is foolish to go against pure momentum plays. You could book profits in pure momentum plays, but should never short them. It is evident in the interviews of ‘market experts’. These experts are increasingly unable to justify prices as the problems of December still remain in a big way yet have nevertheless been coming out with buy lists. These lists too are heavily focused on momentum plays.
The good doctor will also tell you that steroids are bad in the long run because of significant side effects. Secondly, steroids are used only temporarily to support a diseased body. The cure never comes from steroids. I maintain what I wrote in my earlier article, (Markets at 16000 again) the Sensex does not deserve these levels.

Trading strategy

In end 2007, it was clear to many that markets had run ahead of fundamentals. This was clear even at 17000. People who sold out at these levels rued their impatience as they saw the Sensex rallying all the way to 21000. They were vindicated but much later, in January 2008. The call which one is to take is whether to risk selling out early or risk taking big cuts when prices inevitably, fall. What is to be clearly avoided is putting in fresh long-term money at these stages.
The buyers who have bought early on and who are guiding the market through their buying need liquidity to exit at high levels and by producing a one way move they have succeeded in drawing loads of traders back into the market. These traders will be left with uncovered positions the day the market tanks. It is clear that when it does tank, the cut will be savage. I feel a 300 point cut on the Nifty is not out of the question.
If one is to participate in a bull market, participate in the genuine bull run in precious metals. I will write on that soon.

Having said all this, the sheer amount of liquidity means that one can still take a call on the market purely from that perspective. The market is showing all the signs of a healthy bull market. The 300 point cut could also come after the markets hits 6000+. So, it may be prudent to play smart and participate in the rally as the music may continue for some time yet.

Disclaimer: To some extent, I was caught on the wrong side of the rally but am covering ground with fresh investments. I have also gone long on gold and silver.